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Commentary: Mulling a Next Step for China's Macro Policy

07-31 08:25 Caijing

Macroeconomic policy can encourage a stable economy as long as policymakers know when the time is ripe for proper adjustments.

By Caijing chief economist Shen Minggao

(Caijing Magazine) China's economic recovery is apparently running ahead of those in other countries. But its future is uncertain.

The greatest unknown is whether the nation's extremely loose monetary policy can be sustained. And if it's not sustainable, what could mark a turning point, and what might lead up to a policy adjustment?

When an economic cycle is on the upswing, macroeconomic indicators are critical factors for setting macroeconomic policies.

Economic fluctuations are reflections of three, key macroeconomic variations: GDP growth, inflation and asset price levels. Over the past two years, from peak to dip to a swift bottoming out, China's macroeconomic policy has played a major role in balancing these indicators. And we've seen that macroeconomic policy adjustment -- particularly credit policy adjustment – can reshape the total demand and total supply sides of China's economy.

During a precious upward side of the cycle in 2007, GDP growth and the Shanghai A-shares index peaked respectively in the second and third quarters. CPI reached a peak in the first quarter 2008. Then in the autumn, to suppress an asset bubble, the central bank adopted a tighter credit measure and bank lending declined, after growing 17.2 percent in the third quarter 2007.

But less than a year after implementing a tight policy, the central bank canceled credit controls in November 2008. Loan growth started a powerful rebound. The Shanghai A-share index bottomed out at the end of 2008, economic growth reached a low in the first quarter 2009, and consumer prices probably picked up in the second quarter.

This timeline shows how economic indexes affect policy adjustment, and that policy adjustment can guide macroeconomic direction.

Three Scenarios

When policymakers are trying to secure growth before an economic recovery is firm, loose monetary policy can be sustained. But things change when major economic indexes force policymakers to consider policy overhauls. They may choose to fine-tune not only credit policy but also some fiscal stimulus policies, such as those that favor car buying and real estate consumption.

There are several possible ways that the three, major macroeconomic indexes -- CPI, GDP and inflation – may interact in the future. Here are three possible scenarios for the second half 2009:

In the first scenario, consumer price and asset inflation would be negligible. If consumer and asset prices are held within reasonable, tolerable ranges, a relatively relaxed monetary policy is likely to be maintained and economic growth would continue to accelerate. There is a possibility that economic growth could reach double digits by the end of the year.

This prediction has two variations. First, even if monetary policy remains loose, it's questionable whether abnormal loan growth is sustainable. If GDP growth exceeds growth potential, a structural economic overheating would occur and push up inflation.

A second possible scenario is that an asset price bubble could swell and CPI growth could remain relatively mild.

China's trade surplus continued declining in the second quarter, affected by a weak recovery in overseas markets. The trade surplus fell 40 percent in the second quarter year-on-year. As a result, businesses and investors have been dumping capital into real estate and the equity market for value preservation. As asset prices rise, Beijing may have to tighten monetary policy. Reduced credit supply would then suppress economic growth.

A third scenario would see inflation rise quickly but asset prices climb only moderately.

Excess liquidity is likely to push consumer prices higher and lead to inflation. In the first quarter this year, money supply (M2) increased faster than GDP growth by 18 percentage points, and new loan-writing growth led GDP growth by 21.5 percentage points.  These gaps rose to 22.9 and 27.8 percentage points in the second quarter, respectively.

The most likely of these three scenarios is the second, combining a bigger asset price bubble and relatively mild consumer price inflation. Asset prices often rise ahead of CPI inflation. Overcapacity tied to lower external demand is likely to suppress inflation.

For now, the foundation of China's economic recovery is rather weak. It mainly depends on rising demand as a result of investment growth. However, only with relatively fast credit growth can investment growth and related demand be secured. Meanwhile, a weak Main Street economy cannot bolster investment growth in the private sector.

Although there is a high risk of capital flooding the equities market, potential investment returns are attractive. Thus, more speculators are now seeking profits from the capital market. In June, China's foreign exchange reserves exceeded US$ 2 trillion in the context of both foreign direct investment and declining exports. This brought back to the public's attention questions about whether "hot money" would again flow into the market.

What's More Dangerous?

It's commonly understood that a rising CPI would endanger China's economy in the face of worsening income inequality and a massive rural population, which is particularly sensitive about cost-of-living increases. An ugly round of inflation could threaten social stability.

From the Chinese government's perspective, preventing inflation is at the core of macroeconomic control. At the beginning of 2009, the government set a target of a 4 percent annual inflation rate specifically to lower market expectations for higher prices.

An assets price bubble may inflict even more damage on our economy than high inflation. But the Chinese government has the capacity to intervene in asset markets with tools such as credit controls and the ability to adjust land and tax policies.

In addition, China's equity, bond and financial derivatives markets are not very well developed. Financial products are limited and interactions among different markets are small. Even if asset markets undergo some adjustments, their impact on the Main Street economy would be limited. A high savings rate and low leverage for most Chinese families makes these investors less vulnerable than Americans, whose savings rates are low.

A bursting asset price bubble would hurt middle class Chinese the most. Generally, the middle class is less vulnerable than the lower class to risks. But the middle class is the future consumer force. And a capital market collapse would not only destroy the wealth of these investors but also hurt their purchasing power.

On the other hand, commercial banks are the main suppliers of marketplace capital in China's undiversified financial market. The ups and downs of the capital market are closely tied to bank asset quality. Also, fluctuations in the real estate market are even more closely associated with bank asset quality. Not only do real estate developers borrow money for developments, but individuals obtain mortgages from banks. Meanwhile, when a local government is piling up debt, the land it controls can be the most reliable collateral.

Stimulus Theory

Greater effort should be made to improve economic stimulus plans in order to stabilize China's economy.

Considering that the economy bottomed out in the first half of the year, China's economic stimulus package launched in the second half 2008 has achieved predicted effects. Now, what's worrisome is that the asset price bubble is a ramification of current policy. This can lead to trade-offs following the positive achievements of recent months.

China's monetary policymakers should signal a mild adjustment and prevent more radical policy change that could lead to market fluctuations. In addition to raising the bond repurchase interest rate and issuing central bank notes, Beijing should consider raising the required reserve ratio for commercial banks. Also, Beijing should think about setting an annual credit ceiling for all banks at 10 trillion yuan. And allowing banks to securitize and sell credit assets to institutional investors could be a way to reduce their medium- to long-term loan portfolios.

Meanwhile, the nation's investment structure should be improved. To ensure capital for ongoing projects, the number of new development projects should be controlled. Private sector investment in government projects should be encouraged.

An economic recovery offers the best time to ease away from the imbalanced practices marked by more investment and less consumption. As government investments stabilize, fiscal spending should turn to consumption. For example, the government should increase investments in medical care and encourage rural migration to cities.

China's mission to stabilize the economy through the global financial crisis is nearing an end. But the economic recovery is weak. New macroeconomic policies should be in order. In past years, the government has changed policies in the fall. This may be repeated in 2009.


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